Price adjustments under fixed exchange rate, Microeconomics

Assignment Help:

PRICE ADJUSTMENTS UNDER FIXED EXCHANGE RATE:

In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected by a depreciation (appreciation) of a country's currency. On the other hand, in a fixed exchange rate regime, disequilibrium conditions are corrected by changes in domestic prices. A deficit reduces the country's money supply which in turn reduces the prices. The reduction in the country's money supply will tend to increase the interest rate, which in turn dampens the investment and thereby reduces aggregate demand. Consequently, price level will fall which will encourage exports and discourage imports.

At the same time, higher interest rate induces capital inflows that would help in financing the deficit. he process of price adjustment under the fixed exchange rate regime is similar to that of the price adjustment under the gold standard, i.e., price-specie-flow- mechanism. Under gold standard, a country's currency is defined by the gold content. This is to say that a country will be ready to buy or sell any amount of gold at that price. Further, as the gold content in one unit of currency is fixed, exchange rates will also be fixed. For example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold, while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country. 

This is because no one will be willing to pay more than $4.87 for a £1 coin as gold worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US. These gold outflows/inflows measure the size of Balance of Payment deficit/surplus. 

In a deficit situation, the automatic adjustment mechanism is as follows: With gold outflows under trade deficit, country's money supply will fall, which in turn, triggers a fall in internal prices. As a result, exports will be encouraged and imports will be discouraged until the deficit in BoP is eliminated. 

This adjustment mechanism operates in a similar manner even if a country is not following a gold standard. The foreign exchange reserves held by a country is akin to the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes in the foreign exchange reserves which in turn influences the money supply and thereby the domestic prices.


Related Discussions:- Price adjustments under fixed exchange rate

Coase theorem, Discuss the possible solutions for private solutions (Coase ...

Discuss the possible solutions for private solutions (Coase Theorem) Question 8: Demand: P=100-Q Supply: P=Q MEB= 10 Discuss the possibility of over or under allocations of reso

Water meter replacement program, Water Meter Replacement Program: Typi...

Water Meter Replacement Program: Typically water providers install meters at each service address, read meters monthly and charge customers according to their usage. In resid

What do you meant by hoarding, Q. What do you meant by Hoarding? A situ...

Q. What do you meant by Hoarding? A situation in that companies, financial investorsor individual consumers choose to hold hoards of cash or other liquid assets, instead of spe

Labour supply, Discuss how the opportunity cost principle influence a suppl...

Discuss how the opportunity cost principle influence a supplier''s decision to supply labour

Calculate the mean, You are interested in the outcomes of the children in y...

You are interested in the outcomes of the children in your workload in general functioning and school performance, and whether they are related. As a result you decide to collect s

Assignment, In the table below are given the output (X), T.C., and Price fo...

In the table below are given the output (X), T.C., and Price for a firm. Complete the following table, and then answer the questions at the bottom of the table.   X T.C P=A.R

Laws of economics, Do the laws of economics still work today? use the case ...

Do the laws of economics still work today? use the case discussed in class to answer this question or any other examples) (ii) Provide examples of three factors that can shift the

Effected labor markets, If a minimum wage were imposed below the competitiv...

If a minimum wage were imposed below the competitive equilibrium what would we expect to observe in the effected labor markets?

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd